My Blog

March 26, 2008

About five and six months ago there was a small controversy on my blog and on Brad Setser’s blog about the QDII process, which permits Chinese investors to invest abroad through regulated entities called QDII.  The argument was about whether QDII would be successful in helping reduce China’s net capital inflows by sparking investment outflows from Chinese savers who wanted to diversity their portfolios and buy foreign assets. 

The responses to the first QDII offerings were euphoric, and the offerings were vastly oversubscribed almost immediately, and supporters of the argument that QDII would help relieve monetary pressures pointed to the QDII projections of $90 billion in new offerings in 2008 as representing a significant outflow – equal to about 20% of the net expected inflow for the year.  Some of them also argued that because of the sizable H-share discount to the Shanghai markets, Chinese investors in H-shares were assured of returns high enough to overcome the headwind of RMB appreciation. 

Opponents, which included both Brad and me, argued that a rising RMB meant that it would be almost impossible to beat the Chinese bank deposit rate – expected at that time to be about 10-14% in US dollar terms – without taking huge risks, and that after the initial euphoria there would be very little interest in QDII.  We assumed that QDII investing would die out pretty quickly.  Here is what I wrote in my November 30 entry:

If QDIIs are conservatively managed they are most likely going to underperform local investment alternatives.  In that case instead of more money pouring into QDIIs next year I wonder if we won’t see disgruntled investors begin to withdraw their investments as their returns significantly underperform simple bank deposits.  We may see net redemptions next year, rather than more money going into QDIIs.

On the other hand If QDII managers feel compelled to beat the currency-related hurdle to keep their investors, there is the danger that they stretch a little too far for yield and take some ugly risks.  If as a manager you expect prudent investing will lead to redemptions, does that create an incentive to go out too far on a limb?  I think it might, at least in some cases, and I don’t doubt there will be some dodgy ideas peddled to fund managers.  However a nasty performance for one of these QDIIs could sour the whole market, at least in the short term. 

It is hard to see why investors should be taking money out of the country much longer when the best game in the world seems to be to bring money into China, especially as the pressure for RMB appreciation increases.  If QDII investors do reverse their earlier decision, the monetary benefits of the QDII program could actually reverse next year as investors bring their money back home, and with reserves expected to grow anyway by another huge amount, this reversal will only make matters worse.

In January the numbers came out for the various QDIIs and, not surprisingly, they were pretty bleak.  Some of them had indeed taken some big risks – when you have to beat a hurdle of 10-14% hurdle, your only option is to gamble wildly, something that I suspect many investors in QDII did not realize – and the bets turned out badly more often than not.  For those who are interested, in my January 16 posting I discuss a Credit Suisse report that QDIIs had lost an average of 12% since launch.

Since January it seems that things may have gotten much worse.  In today’s South China Morning Post I read the following:

An overseas equity-based fund operated by China Minsheng Banking Corp has been forced to liquidate after its value fell more than 50 per cent, giving mainland investors a hard lesson in the risks of overseas markets. Among the qualified domestic institutional investor funds that have made information public, Minsheng Bank's was the first to be dissolved.

The liquidation, which Minsheng confirmed yesterday, could be followed by similar moves by other fund managers, since mainland QDII products had suffered amid turbulent global stock markets, analysts said.

If I remember correctly there was about $20-30 billion of QDII money raised last year.  If we assume that every QDII fund loses half of the value of the assets under management, and then liquidates, that represents $10-15 billion of new inflows into China.  Since liquidations may take place at less than 50% loss, the inflows will probably be slightly greater.  

Normally $10-15 billion would be considered a large number, but we’ve been so knocked-about by large numbers recently that it seems like a piddling amount – about 2-3% of total expected 2008 net inflows.  I suppose the only good aspect about this whole thing is that having domestic investors lose money in foreign investments does reduce net capital inflows into China, even after the outflows are repatriated. Those investors who got screwed can at least sleep well knowing they have done their patriotic duty and helped the PBoC.

Comments (3) for "First QDII liquidated – reve...

As the old adage says, bad trades catch up with you. I totally agree that we will see more QDIIs liquidate. It is an inevitable result of the combination of the authorities' slow decision making process and the public's sheep flock mindset, adding to those some really bad luck. Long decision time missed the better market entry point. QDII was first discussed at least five years ago when Hang Seng Index was still 10000+. When it finally came out, HSI already doubled. Sheep flock mindset caused irrationality. As I saw it some time last year in a Chinese bank, ppl were crazily buying funds as well as other structured investment products, mostly because they saw others buying, initially misled by the banks' sales ppl. It's like a positive feedback that magnified the signal, the embedded volatility. Now that the equity market is down, and volatility spikes up, they lose money on both equity fund investment as well as options embedded in the yield-enhancing structured notes. Bad luck comes in right on time, giving a hard lesson to both the authorities and the investors. However, as you suggested in the article, the flip side of the story is that finally someone is broke, hopefully bringing back some sense of urgency to the authorities and rationality to the investors. Had the market been strong, the positive feedback would still be magifying the hidden risks. Something that goes up must come down. Finally, I saw this sign while i was at a golf resort with a friend in Shenzhen last week: due to SAFE's requirement, starting from April 1, all golf clubs in Shenzhen will not accept HKD. By Megatone - 3/26/2008 5:23 PM

Megatone, thanks for that last comment -- Shenzhen golf clubs will not accept HK dollars. I think I will use it in my next posting. By Michael Pettis - 3/26/2008 6:43 PM

But isn't this a lesson in risk management? Sure the QDII funds got killed by just going long something, but Shanghai was also down 40%. So what are the options for mainland investors? Long A share, real estate and mattress. It seems to me that the next wave of QDII funds must offer local investors some true diversification. By mgt_watching - 4/14/2008 3:43 AM